By Brendan Conway

What’s the superior investing structure, an exchange-traded fund or a mutual fund? The answer varies, since it depends on so many factors. For instance: the strategy. Is it passive or active? What’s the asset class? The passive approach that’s grown nearly synonymous with ETFs tends to work best in highly liquid markets. There are others where it doesn’t work as well.

But hold those factors equal for a moment. There’s one way that the ETF is clearly superior. That’s in how it handles stampeding investors. Unlike a mutual fund, the ETF forces every investor to pay for his or her own trading costs. In the ETF, it’s up to the investor to avoid buying in a bubble or selling in a panic. You’re not able to fob the costs of buying and selling onto other shareholders, which is effectively what happens in a traditional mutual fund.

As we all know, investors tend to crowd into a bubbly market as prices rise. Then they try to squeeze out the door all at once when prices are falling and the mood is grim. In a mutual fund, you, shareholder, pay for this behavior even if you sit tight during a bear market. That’s because every mutual-fund investor is entitled to receive net asset value when they buy or redeem shares.

In an ETF, by contrast, you get the ETF’s market price at the time of the trade. The price hopefully will be very close to the NAV, but it may not be. If the market is in a panic, it could be far below. If the bulls are stampeding, it will probably be above.

Some background: Berkowitz, who was Morningstar’s mutual fund manager of the decade, came up in the roundtable as an example of a fund manager who’s moving away from the open-end fund structure by closing FAIRX to new investors and, per Morningstar’s Ben Johnson, has suggested an openness to fund structures that put more limitations on investors’ ability to move in and out of the fund in ways that harm the strategy.

But AdvisorShares’ point is something like this: Why try to tell investors what they can and cannot do when you can use a structure that leaves it up to the investor whether he benefits from his own behavior?

From AdvisorShares, on Fairholme:

[T]he mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, First, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.

If this same scenario happened in an ETF, the hot money would bear their own costs, paying their own spreads and commissions, and baskets of securities would be delivered to the fund. And if the reverse scenario occurred and the hot money left, the departing shareholders would pay their own costs of commissions and spreads, and securities would be delivered out in kind creating a future tax benefit for the long-term shareholders. This exemplifies the greatness of an ETF structure, where each shareholder pays for the cost of their own activity, and long-term holders can benefit from short-term holders who help create better tax efficiency and smaller spreads. And, it’s one class—everyone is treated equally, and the retail shareholders can benefit from the economies of scale by investing along side of institutional investors.

It’s a subject we’ll revisit again on this blog. In the meantime, this isn’t to suggest that mutual funds are never the right option.

The argument for mutual funds and closed-end funds tends to be strongest in illiquid markets — a case I’ve recently made about senior loans and previously about microcap stocks.

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